The fragile tax structure in Puerto Rico

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The Puerto Rico government set a high hurdle for itself last year when it ramped up its 2014 tax revenue projection to $9.5 billion from the $8.3 billion collected in 2013. It did this by expanding the tax base for the sales and use tax (SUT) by approximately 26 percent, increasing corporate income tax rates and reversing reductions planned for the corporate excise tax (Act 154) paid by multinationals operating on the island.

The Act 154 tax rate was on track to be reduced to 2.5 percent in 2014 and then expire in 2016. Instead, the tax, which comprised 20 percent of 2013 revenues, was increased to 4 percent and extended to 2017.

The additional revenues from these tax increases allowed the government to borrow less for deficit financing in 2014, but created a high revenue threshold since the economy remains mired in an eight-year recession.

Corporate tax collections increased sharply in 2014, while individual and non-resident withholding tax collections have fallen year-over-year. This appears to reflect a weakened economy and a shift to a greater reliance of tax revenues from multinational and domestic corporations.

Corporate income, Act 154 excise and non-resident income taxes accounted for almost 63 percent of year-to-date 2014 revenues. The proportion of corporate taxes will likely increase with April’s historically large collection.

The Commonwealth believes that its original estimate of $9.525 billion in total General Fund revenues continues to be accurate, although it recently revised its estimates of certain individual revenue items after the experience of the first six months of the fiscal year.

The most significant revisions are a projected reduction in sales and use taxes [SUT] of the central government from $865 million to $614 million (a reduction of $251 million), and a projected reduction in individual income taxes from $2.088 billion to $2.004 billion (a reduction of $84 million), which would be offset by a projected increase in corporate taxes from $2.123 billion to $2.513 billion (an increase of $390 million).

In an effort to broaden the revenue base, Puerto Rico has passed several laws that create low tax rates for overseas companies and investors who relocate to the island. The Bond Buyer reports:

Over the last few years Puerto Rico’s government has passed four laws to attract service companies to the island, [Alberto Bacó, Puerto Rico's secretary of the Department of Economic Development] said.

It passed an international banking center law that places low taxes on international banks located in Puerto Rico. It adopted an international insurance center law to also offer lower taxes on this industry. It passed Act 20 specifying that companies moving service operations to Puerto Rico would be taxed at a 4% rate. Finally, it introduced Act 22, which exempts investors who move to the island from having to pay taxes on certain forms of investment income.

These laws are attracting certified public accountants, hedge funds, law firms and architectural firms, Bacó said.

Puerto Rico is aggressively marketing itself to companies in Latin America and Spain as a place to set up shops that can be bridges to the rest of the U.S., Bacó said. The island’s workforce is bilingual. Offices can be set up with half the costs found in the continental United States and Puerto Rico has lower taxes, Bacó said.

Casey Research, a paid investor newsletter firm, is aggressively touting relocation to Puerto Rico as a way for American investors to escape U.S. taxes. Gaining these tax advantages would require a permanent move to Puerto Rico (original emphasis):

Puerto Rico recently slashed its taxes on dividends, interest and capital gains to ZERO for new residents.

Additionally, there are enormous benefits for service-related businesses — like consultants, accountants, software developers, research and development, etc. — in the form of a top 4 percent corporate tax rate. This amounts to a pittance in comparison to combined U.S. federal, state and sometimes city income taxes.

The Bond Buyer notes that the Puerto Rico government has shifted the emphasis of its annual investor conference from feting bondholders to attempting to attract wealthy investors this year:

[The Puerto Rico Industrial Development Company] is hosting an investment summit on April 23rd and 24th. In the past these summits were arranged by the Government Development Bank of Puerto Rico and geared to those who were interested in buying the government’s bonds. This year it will be focused primarily on convincing hedge funds and wealthy investors to move to Puerto Rico.

Although there are still three months of tax revenues to be reported for 2014, Puerto Rico’s proposed 2015 budget is expected to be released on April 29. Governor Alejandro García Padilla has promised that it will be balanced, which will require approximately $800 million in expense cuts. Caribbean Business reports:

‘Tatito’ Hernández says the ‘historic budget’ will slash $800 million in spending and make public corporations self-sufficient.

The ‘historic’ budget Gov. Alejandro García Padilla will present will not only be completely balanced but will also call for a broad ‘re-engineering’ of government agencies and public corporations.

As part of the process, public corporations will have to begin living within their means and will be given broad new powers to renegotiate collective bargaining agreements with employees, contract terms with suppliers and long-term debt agreements with creditors.

Much has been made recently about all the restructuring experts who have been hired by the Commonwealth, among them New York-based Cleary Gottlieb. Lee Buchheit, one of Cleary’s principals, co-authored an interesting paper last October, titled: “Revisiting Sovereign Bankruptcy,” which contained the following quote on sovereign credit defaults:

“There is evidence that policymakers are often reluctant to restructure their debts and sub-optimally postpone unavoidable defaults (e.g., Borensztein and Panizza 2009; Levy Yeyati and Panizza 2010; IMF 2013). Delayed defaults can lead to the destruction of value because a prolonged pre-default crisis may reduce a country’s capacity and willing willingness to pay. Its capacity to pay is reduced because procrastination prolongs the climate of uncertainty, high interest rates and restrictive fiscal policies that are ineffective in avoiding default but amplify output contractions. Delayed defaults reduce its willingness to pay because electors that have suffered long periods of economic austerity are less likely to support a creditor-friendly debt restructuring (our emphasis).” Now, doesn’t this sound familiar to you?

Author Profile

I’m Cate Long and I write about the retail fixed income markets including municipal bonds. My primary interest is creating tools and systems to help retail investors understand bond markets. I’ve worked for a number of years with industry standards organizations, regulators and Congress to help craft a more transparent and fair framework for investors to participate in the fixed income markets. I'm a guest contributor to Reuters.com. Any opinions expressed are mine alone.